What are we to make of Beijing’s shock devaluation? With the UK media classes fixated on Jeremy Corbyn, a potential Labour leader even his supporters acknowledge won’t ever be Prime Minister, you may not have clocked recent events in the People’s Republic. The actions of the Central Bank of China, though, and the near-term path of the yuan, could have a big impact on UK living standards.
Having grown 9.8pc a year since the late-1970s, the Chinese economy now outstrips America on a purchasing power parity basis (adjusted for living standards). With the big Western economies still shaky, if this Eastern giant stalls, the UK’s nascent recovery could easily reverse. And if Chinese stocks and bonds crash, with “contagion” spreading to financial markets elsewhere, that would upend British politics.
The danger of such a China crisis last week came into sharp focus. On Tuesday, Beijing took the radical step of announcing a devaluation, which saw the yuan drop 2pc against both the dollar and the euro, the largest one-day adjustment in over a decade. The following day, as the weight of money in the market got behind the fall, the Chinese currency lost another 2pc, appearing to take policymakers by surprise. At the time of writing, China’s usual highly secretive monetary authorities are heavily intervening – selling dollars and buying yuan – to stop it falling much further. Or, at least, that’s what we’re told.
Having been explicitly pegged to the dollar until 2005, the Chinese currency has for the last ten years remained closely-controlled under a “managed float”. The central bank, in other words, has used its vast $3,700bn haul of foreign exchange reserves, as well as capital controls, to keep yuan within a strict trading band. Up until last week, the largest single-day move against the dollar this year had been just 0.15pc. So a 4pc drop in just a few days is huge – the biggest yuan shift since the mid-1990s.
What’s alarming is that, were this depreciation to get out of hand, with the Chinese currency dropping very sharply, import prices and inflation would spike. That could force Beijing to reverse recent interest rate cuts, potentially bursting China’s property bubble and, at the very least, undermining the broader economy – which, for some years now, has acted as a locomotive, pulling along the rest of the world.
Annual Chinese GDP growth recently dropped below 7pc on official data for the first time in a quarter of a century, among suspicions the true figure is much lower. In response, Beijing has cut rates four times in seven months, while easing reserve requirements to boost bank lending. Sluggish Western growth is now hitting Chinese exports, which plunged 8.3pc last month. That rattled the authorities, causing them to whack the panic button, lowering the yuan to give the all-important export sector a boost.
By signalling its openness to a weaker currency, though, Beijing may have provoked a rout. Certainly, the central bank on Thursday staged an extremely rare public defence of its actions. “In the long run, the yuan remains a strong currency,” said Zhang Xiaohui, Assistant Governor of the People’s Bank of China. “A fixed exchange rate looks stable, but it hides accumulated problems”.
Such “accumulated problems” refer to the fact that since the 2008 financial crisis, the yuan has appreciated by no less than 39pc on a trade-weighted basis. Over the last year alone, the Chinese currency is up 13pc against the county’s main trading partners, according to data from the Bank of International Settlements. The Beijing government attributes much of this rise to so-called “currency wars” instigated by the West – as the likes of the US and UK, and now the Eurozone, have undertaken quantitative easing on a vast scale.
While many in the US Congress have long accused China of “currency manipulation”, Beijing views the world differently, arguing that QE is designed in part to keep Western currencies weak which, in turn pushes up the yuan. That not only gives Western goods an advantage on global markets, but lowers the value of the hard-currency loans that China has extended to the West – not least the US.
The generous interpretation of Beijing’s attempts to lower the yuan last week is that the Chinese central bank is, in its own words, moving towards a “more market-based” foreign exchange regime. This is what the West has called for over many years. Certainly, Tuesday’s announcement led to speculation that China wants to convince the International Monetary Fund to classify the yuan as an official reserve currency – along with the dollar, yen, euro and sterling.
This autumn, the IMF publishes its review of the Special Drawing Rights, the official currency basket used by central banks everywhere to denominate their reserves. Inclusion of the yuan, if matched by a loosening of capital controls by Beijing, would mark China’s full integration into the global financial system. But that will only happen if, as the IMF has prescribed, the yuan becomes “more flexible”.
More hard-nosed observers, myself included, will judge that Beijing, while it has an eye on the IMF’s decision on SDRs, is firing back a “currency war” salvo. While remarking that the yuan had become “too volatile”, and issuing warm words to reassure Western nations fearing a meltdown, the Chinese authorities still cut their announced yuan reference rate on successive days last week, intervening to make sure their currency slide didn’t get out of control but doing very little to actually reverse it.
It seems to me, in fact, that Beijing has rather astutely picked its moment. The West has long insisted on a more “market-based” Chinese currency. What better time to introduce it than when the economy is weak and the yuan is pumped up by Western QE? Currency flexibility then amounts to a weaker yuan that helps Chinese exporters, rather than a stronger Chinese currency that better suits the West.
UK trade with mainland China is growing quickly. The country accounts for 8.7pc of our imports of goods, up from 4.6pc ten years ago. Exports to China are 4.8pc of all UK goods sold abroad, up from just 1.4pc in 2005. Include Hong Kong, and the related trade in financial services, and those import and export shares rise to 10.3pc and 7pc respectively. As such, a weaker yuan will make the UK’s sizeable imports from China cheaper, pushing down inflation. Beijing’s action could even delay the Bank of England’s first interest rate rise since 2007, now not expected until mid-2016.
While that’s good news for indebted UK households, if the rope slips in the Chinese central bank, and the yuan crashes, the subsequent Chinese slowdown will impact our economy very badly. For now, the Chinese authorities probably have enough reserves, and common sense, to avoid a currency collapse. They want a much weaker yuan and that’s what they’ll get, however much Congress huffs and puffs – not least because Beijing, if it wants to, can play havoc with American interest rates by signalling it may start dumping part of its vast stock of US Treasury bills.
My broader concern is that we’ve become so complacent about fast Chinese growth, just as we did with Japan in the 1980s, that it’s hard to envisage it will end. The reality is, though, that China has massively over-invested, the banking sector is full of non-performing loans, stock valuations remain bloated and many companies have borrowed heavily overseas. If the Chinese central bank is concerned enough to yank down the currency, making those foreign loans even bigger, then maybe it is time to worry?